Asset Allocation And Higher Interest Rates

One of the major concerns for investors for the near-term future is the expected rise in interest rates. With the price of money at or near all-time lows in the modern era, the obvious question arises: what to do now? The short answer: more of the same. Assuming, of course, that your strategy is one of remaining broadly diversified across the major asset classes and maintaining a robust rebalancing strategy. That doesn't satisfy some analysts, who argue that more radical measures are necessary. It's different this time, the reasoning goes, and so strategy must be different. Well, it's always different, but a prudent strategy of broad asset allocation and rebalancing tends to deliver average to above-average results vs. a broad array of portfolios that try to do better.

This history is worth considering as we look forward and assume that interest rates will rise in the years ahead. But it's crucial to consider why rates will rise? In search of an answer, it's helpful to start by asking: Why are rates currently so low? Critics say it's all due to a misguided dovish policy on the part of the central bank. But that's too simplistic. For additional perspective, consider last Friday's speech by Fed Chairman Ben Bernanke. He noted that long-term interest rates can be decomposed into three components: expected inflation, the outlook for short rates, and a term premium (the extra yield associated with holding longer term bonds. vs. short-term instruments). Using one model to estimate these components, he offered this summary of decomposing the benchmark 10-year Treasury yield through recent history:

Note that expectations for inflation and short rates have fallen in recent years. What's going on here? Bernanke explains:

Long-term interest rates are the sum of expected inflation, expected real short-term interest rates, and a term premium. Expected inflation has been low and stable, reflecting central bank mandates and credibility as well as considerable resource slack in the major industrial economies. Real interest rates are expected to remain low, reflecting the weakness of the recovery in advanced economies (and possibly some downgrading of longer-term growth prospects as well). This weakness, all else being equal, dictates that monetary policy must remain accommodative if it is to support the recovery and reduce disinflationary risks. Put another way, at the present time the major industrial economies apparently cannot sustain significantly higher real rates of return; in that respect, central banks--so long as they are meeting their price stability mandates--have little choice but to take actions that keep nominal long-term rates relatively low, as suggested by the similarity in the levels of the rates shown in chart 1. Finally, term premiums are low or negative, reflecting a host of factors, including central bank actions in support of economic recovery. Thus, while the current constellation of long-term rates across many advanced countries has few precedents, it is not puzzling: It follows naturally from the economic circumstances of these countries and the implications of these circumstances for the policies of their central banks.

The key message is that long rates will rise when economic growth is stronger--and not the other way around. Bernanke noted several recent forecasts of higher 10-year rates from different sources, including the Congressional Budget Office, the Survey of Professional Forecasters, and the Blue Chip Financial Forecasts survey. It's anyone's guess how accurate these forecasts will be in terms of timing. It's inevitable that rates will rise--we just don't know when. The larger point is that higher interest rates are likely to accompany stronger macro conditions.

This implies that any losses in bonds that are associated with higher rates will be offset by gains in equities and other assets that are direct beneficiaries of stronger growth. You could, of course, abandon bonds now and load up on equities in anticipation of this shifting macro outlook. But if you're wrong on the timing, your portfolio could suffer. In fact, quite a number of strategists have told us in recent years that the bond rally was over, only to find that the prediction was premature. Caveat emptor on moving your asset allocation to extremes in one fell swoop.

History suggests that remaining diversified and perhaps boosting the frequency of your rebalancing will remain a competitive strategy for navigating the future. Perhaps it's also wise to start winding down your strategic allocation to bonds, and doing the same in reverse for stocks and other risky assets that might benefit from stronger growth. In any case, radical changes should be directly correlated with your confidence on forecasts.

For most folks, however, hedging the risk of an uncertain future still prompts the standard advice: hold a wide mix of asset classes and rebalance periodically. Yes, we've heard this advice before. But if it's not broken, don't fix it.